As we reach the end of 2017, it is impossible not to reflect back on the fantastic rally in risk markets.
Yet again, risk markets defied expert opinions and delivered to investors a massive gift of capital appreciation. If there has been one mantra that has worked this year, it was “buy the dip”, though more recently it could be alternately characterized as “fear of missing out”. Equity markets still look and feel young, even though danger signs abound following the 10-year rebound from the depths of the financial crisis which is almost forgotten.
So where is the hidden fountain of youth that is driving the spectacular performance of markets in the face of political and geopolitical turmoil, high asset valuations, and a tightening Fed? Will it keep flowing in 2018? What signs should we watch for whether we’re looking at more of the same or if we’re looking for an about face?
To answer these questions, one has to only look at the German government yield curve, especially the very short end as represented by the German two-year maturity “Bund”. A recent two-year Bund was issued in November of this year at an issue price of 101.489 and a coupon of 0%. In other words, the Bund will pay a holder no interest if held to maturity, and in addition, the holder will receive only par value (100 Euros) for paying 101.489 Euros . This corresponded to a yield of approximately -0.75%. If held to maturity, this negative yield would correspond to a guaranteed loss. And I think a guaranteed negative return on the bonds of possibly the most creditworthy country in the world today has something to do with the performance of all assets, not just risk assets. When volatility across all assets is as low as it is today, and equity markets are delivering 20% a year, it really feels cowardly to hide out in negatively yielding assets, unless, of course one has to. The guarantee of certain wealth destruction in holding European (and Japanese) fixed income instruments is the source of many other asset price distortions and hence the indicator to watch for when the time for reversal is close.
German two-year government bond yields of -0.75% have dragged French (-0.55%), Spanish (-0.40%), Italian (–0.30%) and even Greek (2%) two-year yields down to unprecedented levels. And if you believe what the European Central Bank is saying, low yields in Europe are here to stay for the foreseeable future. Despite a pick-up in European economic growth, the ECB still sees inflation running below their target. As long as Mario Draghi is in charge, most investors seem to think it unlikely that the $35 billion of monthly security purchases by the ECB is going away. And Draghi is here till at least 2019.
In the face of negative European yields, the US bond market looks like a high yield investment opportunity to capture spread, with no credit risk, for investors in the rest of the developed world. Note that many European high yield markets are actually yielding below US treasuries. Unless you are forced to choose credit risk over currency risk, which one would you choose? If you can borrow at low to negative rates in Europe, and invest, for example, in the US two year note at 1.75%, there is an almost 2% cushion in terms of the movement in exchange rates before the carry advantage goes away. 2% yield in a negative yield environment is enormous indeed. This type of cross-currency yield arbitrage has the risk that currencies move against you. So if you borrow money in Europe and buy treasuries in the US, and the dollar depreciates, it could mean losses. But today hedges against currencies moving are so cheap that you can essentially protect much of the carry with cheap currency options.
In the equity markets, the low yield environment creates incentives for corporations to issue lots and lots of debt, and use the proceeds to buy back stock. The incentives are clear for issuers: issue debt to buy stock and for investors to capture any spread they can in a world awash with liquidity from the negative yield spigot, and both investors and corporate treasurers respond to incentives. Thus a low yield environment seems to put a floor on every pullback in the equity market. If one can borrow at zero and harvest a 2% dividend yield from the equity markets, it is hard to argue against doing so with an implicit promise of easier financial conditions and monetary policy if equity markets sell off.
Which brings us to the question of why this almost “free-lunch” exists in the first place, i.e. how can you capture cross currency yield and still hedge out much of the currency risk using options? The short answer again leads us back to the fountain of youth, the low yields on short-term bond investments. When yields are low, the simplest way to enhance yield is to become a “shadow financial insurer”, i.e. by selling financial options and earning the insurance premium, including currency options. And as I have written before, when everyone is doing it in every market, implied volatilities collapse across all assets. Even without having to resort to fancy financial engineering, the path to profits in the minds of investors is likely to be lined with cheap money that funnels itself into the liquid risk markets in the US.
So the next time we are confounded by why markets keep going up in the face of geopolitics and expensive asset prices just look at the German bond market and the need for yield, and we should have a clue. It’s a gift that keeps on giving, for now, though the last few days have started to see yields beginning to grind higher. Ultimately all good things have to come to an end, and when it comes there will be little warning. For the time being, the negative yield distortion is going to continue to provide a bid to asset prices.
So what should an investor do to position for 2018? While there is no shortage of differing schools of thought, there are some general themes to keep in mind. First, investors should be wary of putting too much of their money in cash, especially where there is a significant real and nominal yield penalty to doing so. This theme extends to investing in bonds of countries where yields are at all-time lows. Second, investors should not be too scared to take risk. While equities are at all-time highs in terms of valuation, there is no reason why investors cannot take equity risk and protect their downside, since option premia on the downside are so low. It’s certainly better than monetizing gains and missing upside opportunity costs and paying a hefty capital gains tax bill. Finally, the pricing of dollar assets, and the dollar itself does not reflect the fact that the dollar does well when markets move a lot, i.e. when there is either a crisis or a “melt-up”. With positive carry and the yet unpriced value of the generational tax reform in the markets, being long dollar denominated assets is likely to be the beneficiary of the fountain of youth of negative yields in Europe.
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.